Paper Title

Abstract

Is Default Risk Priced? Empirical Evidence in the Presence of Fat Tails

Purpose

An empirical study of whether distress risk exposure is reflected in the cross section of equity return premiums.

Originality

It is common to study and measure risk premiums, such as that associated with the risk of financial distress, in terms of the differential between mean returns of the extreme portfolios (i.e. high and low distress risk). Not only are such approaches sensitive to model specification, distributional assumptions and the measurement error, they do not address directly the question of whether risk exposures and measured risk premiums are monotonically related - as would be expected if distress is viewed as a systematic source of risk. The current study applies the recent methodology of Patton and Timmerman (2010) as a direct test of the monotonicity hypothesis.

Findings

Using a formal test of monotonicity this paper finds little evidence of a systematic relationship between expected return and distress risk premiums. Statistically significant distress-related equity premiums appear observable at the extremes of exposure only.

Practical and Social implications

This finding suggests that prior empirical results (see: Dichev, 1998; Griffin and Lemmon, 2002; Vassalou and Xing, 2004; and Campbell, Hilscher and Szilagyi, 2008) that find either positive or negative systematic distress risk premiums have been driven by measurement error and outliers within the lowest and highest distress risk (or extreme) portfolios.